Merchant Discount Rate (MDR) on the Unified Payments Interface (UPI): Balancing Costs and Benefits in the Indian Banking Industry

Mr. Sachin Mehra, the Chief Financial Officer (CFO) of Mastercard, recently commended the unified payments interface (UPI), describing it as "impressive on multiple fronts." However, he also acknowledged that for participants in the ecosystem, it can be a challenging experience, resulting in financial losses. The debate surrounding UPI MDR (Merchant Discount Rate) has become a significant concern for banks and ecosystem participants. While they incur costs, there are important advantages that should not be overlooked. Understanding this intricate dynamic is crucial in comprehending the evolving landscape of digital transactions.

Banks face a two-fold challenge in dealing with UPI MDR. Firstly, they bear a Transaction Service Provider (TSP) cost of 3-4 basis points (Bps), along with an operational cost of 1 Bps. Secondly, regulations prevent them from passing these charges on to end customers, posing a considerable financial hurdle.

Settlement cycles add another layer of complexity. Banks receive payments in cycles from NPCI (National Payments Corporation of India) but are required to provide instant settlement to retail customers. This has led many banks to adopt a T+1 settlement policy for current accounts, mitigating some of the liquidity strain.

However, it's important to note that while UPI does come with costs for banks, it also offers several advantages. Firstly, there's a significant reduction in expenses related to storing, transporting, disbursing, and managing physical cash, which can be a considerable financial burden. Additionally, with UPI, excess cash is retained in bank accounts, potentially yielding minimal to no interest, yet contributing to the bank's liquidity.

In response to the challenges posed by UPI MDR, many players in the industry are exploring alternative revenue sources. Initiatives such as Soundbox, credit services, insurance offerings, and more are emerging, providing additional revenue streams for banks.

The UPI platform achieved a historic milestone by surpassing 10 billion transactions in August. This momentum continued with an even higher figure of 10.56 billion transactions in September. While the transaction value saw a marginal increase of 0.3%, reaching Rs 15.8 trillion from Rs 15.76 trillion in August, the growth trajectory remains impressive.

The recent PR push from Mastercard sheds light on the struggles faced by traditional payment processors. Their business model, which has been criticized for overcharging merchants with predatory pricing, is under threat from the rising popularity of UPI and RuPay. This signals a fundamental shift in the payments industry.

Navigating the landscape of UPI MDR requires a nuanced understanding of the costs and benefits for banks. While there are challenges to be addressed, it's essential to acknowledge the substantial advantages, including reduced cash handling costs and improved liquidity. The Indian government has announced a Rs 1,300 crore scheme to incentivize banks, payment gateways, and UPI players for transactions. To be eligible for the full incentive, banks were required to show at least 50% year-on-year growth in UPI transactions by the end of the last quarter of the scheme. In FY2022, the government spent Rs. 1,044 crore as a subsidy for processing UPI transactions at zero charges. The funds allocated for digital payments subsidy are generally disbursed to fintech companies and banks that promote UPI transactions. As the industry adapts, exploring alternative revenue streams will play a crucial role in sustaining profitability. The ongoing success of UPI reflects a broader transformation in how India conducts its financial transactions, with traditional players needing to adapt to this new reality.